The rating game

Rating agencies are paying ever more attention to operational risk in assessing financial institutions. Rather than fear this development, Giles Bryan argues, smart banks will turn transparency in operational risk and compliance with Basel II into a competitive advantage.

Everyone thought it would happen and it has. Basel II is being dumbed down and dissenters are saying they will not accept more complicated forms. The much-hyped attempt to create a finer and more level playing field is being cut up by international dissent. Or so it would seem, with US organisations deciding that despite almost five years of discussion and revision, the Basel II accord doesn’t really suit any but the largest.

Meanwhile, US bank-regulation agencies have dropped a bombshell. “The US authorities intend to apply only the so-called advanced (A-IRB) version of Basel II. We expect to require about 10 large US banks to adopt the A-IRB approach, but we anticipate that a small number of other large entities will choose to adopt it as well after making the necessary investment to support their participation,” Roger Ferguson, vice chairman of the US Federal Reserve, explained to the US Congress, and the whisperings in the silicon pipes of power hinting at a revision to the operational-risk methodology. And in Europe, Jean-Claude Thebault, head of the financial-institutions directorate at the European Commission, said: “We must be ready to provide for appropriate differentiation from the Basel framework in the limited circumstances where this is necessary to take account of particular important features of the EU context.”

However, companies such as JPMorgan are correct: Basel II is good practice, and firms that want to do good business will hold to its principles. That’s why the top firms in each jurisdiction might be grumbling, but they are complying. Perhaps also, those firms that are taking the operational-risk elements most seriously are those that are more aware of the growing power of the ratings agencies, which have their own perspective on operations and operational risk. Their perspective is that operational risk is becoming “increasingly central to the fundamental analysis of a rated institution”, says Brendon Young of Moody’s, and that operational risks are going to become transparent to the market whatever regulatory stance individual institutions choose.

Thus neither adjustments to the regulatory stance, nor institutions abdicating from the most sophisticated elements of Basel II, are necessarily the setback they might appear; for while banks and regulators bump their gums over operational-risk management, ratings agencies are sharpening their claws. And, in the long-run, many more banks, both in Europe and the United States, will conform to the highest standards rather than have their credit ratings downgraded in any way – they are just doing their best to push the date of compliance out for as long as possible. For many, the credit rating is one of the most significant measures of success (downgrades are followed by executive ‘reshuffles’), and the credit rating is a vital part of the business equation given its intimate relationship with the cost of debt.

It’s effectively a transfer of power from accountants, directly through regulators, to ratings agencies – which is where the power should rest since, by their very mandate, they offer the transparency both market and consumer seek. Ratings agencies are also the people best placed to charge for this service without being accused of either artificially extending their work or being too intrusive; they offer real value for money for financial institutions, regulators and consumers.

Not that ratings agencies can afford to acknowledge explicitly this change in the power balance, for the three major ratings agencies inhabit a privileged zone, licensed by the regulators, effectively operating as a cartel, and welcomed by their customers, the banks, as long as the ratings don’t changes too suddenly or dramatically.

So, although Moody’s has put a couple of papers about the importance of operational risk out into the markets and is educating its analysts on operational risk, and Fitch has dabbled with the purchase of Op vantage, everything is being done very softly, softly. Effectively, banks and regulators need to ask the ratings agencies to take on this new operational-risk analysis. Everyone knows this crucial work needs to be done, accounting/consulting firms can do it and regulators can’t afford to do it (they don’t have the personnel), but ratings agencies can’t be seen as being pushy. This is because of the considerable additional work (money) required to include operational risk within the credit rating. (No more boardroom presentations and good lunches – it’s heads down in the operations basement for a couple of weeks).

Ratings agencies don’t want to offend regulators by making it clear who holds the power, and who is getting all the cash, lest they find their privileged status withdrawn. Nor do they want to offend their banking customers by forcing them to expose sections of their operations that might not be yet sorted out. And, for the sake of their brand independence, they can’t be linked with anything that smacks of consultancy. So, for the moment, in the financial-services savannah, there is a potent silence, with claws still sheathed and muscles unflexed.

Change will follow the third Basel II consultative paper in May, which leaves few doubts about the expectations of the industry with regard to operations and operational risk. The timetable will be set for the most part (though hold your breath for delays caused by not using the Lamfalussy process), and the smarter firms will start moving ahead in dramatically improving operational procedures and reducing operational risks in order to shine in their advanced measurement approach assessments. And as soon as they think they can get a competitive advantage through getting their operations and operational-risk practices assessed as part of the credit ratings, they’ll be snapping up the ratings agencies offering to do that work.

Given that operational risks are precisely those that are most likely to cause unexpected and catastrophic failure (Enron, Worldcom, AIB), transparency on operational risk is likely to provide significant competitive advantage. After all, who would do business with an organisation that appeared gleaming, slick and efficient, but when it came to discussing its internal machinations was pleading the fifth amendment?

Giles Bryan is director, strategic consulting for GFT UK in London.